Construction Financial Management
- Intro to Financial Management & Cash Flow
- Financial Statements For Construction Businesses
- Income statement
- Balance Sheet
- Cash flow statement
- Forecasting cash flow
- Managing cash flow
- Financial controls to prevent fraud
- Intro to Contractor Finance
- Where to find loans & other funding
- Financing equipment
- Invoice factoring
- Using credit cards wisely
- Calculating the true cost of financing
- Tips to manage cash flow
How do you measure the success of your construction business? Is it just by profits, or how much cash you have in the bank? With the current volatility in the construction industry, owners need to know more about their business’s financial standing and how profitable their sales are. Using the right KPIs to measure your success can give you insights that turn your business into an elite, streamlined construction machine.
What are KPIs?
Key performance indicators (KPIs) are measurements that indicate how a business is doing in relation to its business objectives. These objectives might include profitability, cash flow, and getting paid. Each company chooses what KPIs they want to track, according to what is most important to them. There are some indicators that might be called “standard,” while the rest are more custom and depend on the type of company.
Why should construction companies care about KPIs?
First of all, KPIs are often used by banks and sureties when assessing whether a construction company is a good credit risk. These companies want to know that a business is making enough money to pay its bills, and is on solid financial footing.
The other reason KPIs are important, especially now, is that they keep ownership informed of how well the company is doing. Reliable KPIs help construction business owners and CFOs make changes if they are needed.
There are many KPIs that a construction company may want to look at. For right now, we’re going to focus on key financial metrics and some project-oriented ones that could be helpful for contractors.
Financial KPIs for construction
Gross profit margin
Gross profit margin = (sales – COGS) ÷ sales
Gross profit margin (also called gross margin ratio) is the amount of money a company makes when cost of goods sold (equipment, labor, and materials) is subtracted from sales. It is expressed as a percentage of sales.
A higher gross profit margin means you are making more money on your projects. It does not include administrative and overhead expenses. Construction company owners and CFOs will want to track this KPI closely and share the info with project managers and estimators.
Net profit margin
Net profit margin = (sales – COGS – operating costs – interest – taxes) ÷ sales
Net profit margin is the amount of money a company makes when operating costs and cost of goods sold are subtracted from sales. It is also expressed as a percentage of sales. The percentage reflects how much of each dollar you earn is actual profit.
A higher net profit margin means you are making more money for your business overall. If a contractor or supplier is continually having a low net profit margin, then it may be time to raise prices.
Net cash flow
Net cash flow = cash in – cash out
Net cash flow is a measurement of how much money is moving through a business during a specific period of time. To calculate it, take the amount of money that comes into the business during a given period and subtract the amount that went out during that same time.
Positive net cash flow amounts mean the company is bringing in more than it spends. Negative net cash flow means that your business is spending more cash than you bring in. This is typically a red flag, as it may indicate that your accounts receivable might be a problem. Stepping up collection activities is a good idea if receivables aren’t being paid.
Negative net cash flow amounts are not always bad, if the company has savings or additional cash resources to tap. A construction company might also see negative cash flow in the early periods of aggressive growth, before their marketing or business development activities start to pay off.
Use a cash flow projection report to help analyze cash flows over many periods to get a better understanding of what to expect in the future. Construction CFOs and other financial or accounting managers will want to keep an eye on this KPI. The company needs to be prepared to take action if cash flow is consistently negative.
Quick ratio = (current assets – inventory) ÷ current liabilities
A quick ratio (often just called a “quick”) shows a company’s ability to pay short-term liabilities. The more assets and less liabilities a company has, the better the quick ratio. Ratios of 1.5 to 3 are good, as is stability over time.
A construction company’s “quick” is often used by banks and financial institutions to gauge a construction company’s ability to repay a loan.
Accounts receivable turnover
Accounts receivable turnover= Net sales on credit / [(beginning AR balance + ending AR balance) ÷ 2]
Accounts receivable turnover (or AR turnover) shows many times in a period your pay applications or invoices are paid in full by customers.
The period is determined by the amount of sales used in the calculation and the beginning and ending AR balances that are chosen. The higher your AR turnover, the quicker you are collecting your money.
Getting paid is notoriously slow in construction; keeping a close eye on your AR turnover will help you prevent a much bigger payment problem.
Slower collection times can really hamper a construction business’s ability to pay its bills and employees. A good credit policy includes tools like preliminary notices, invoice reminders, and mechanics liens that help speed up payment.
CFOs and project managers need to work together to collect outstanding payments as soon as possible. On-time payment helps keep cash flow positive.
Working capital = current assets – current liabilities
Working capital is a measurement of a company’s ability to pay short-term financial obligations.
Current assets include cash in the bank and accounts receivable. Liabilities include accounts payable and short-term loans. The higher the working capital number, the better the company’s financial health.
If a contractor has negative working capital, it means they don’t have enough money on hand to pay their current bills. A construction business with negative working capital needs to get their hands on cash as soon as possible. Options may include bank loans and invoice factoring. Banks and financing companies will look at this KPI when making lending decisions.
Accounts payable turnover
Accounts payable turnover = Total purchases / [(beginning AP balance + ending AP balance) ÷ 2]
Accounts payable turnover (or AP turnover) shows how many times in a period the company is paying its outstanding bills. The period is determined by the amount of purchases used in the calculation and the beginning and ending AP balances that you choose.
The more AP turnover a contractor has, the quicker they pay their bills. If your accounts payable are delayed, it could mean additional interest charges or other penalties. Improving AP turnover can help you cut costs.
If your construction company is having trouble paying its bills in a timely manner, consider a bank loan, invoice factoring, short-term credit (such as credit cards or a line of credit), or other collection processes.
Project KPIs for construction
Most of the financial KPIs above can also be applied to individual construction projects to determine their profitability or how long it takes to get paid. The indicators below are more project-related and are good to know when assessing bid accuracy and employee productivity.
Cost variance (CV)
Cost variance = Planned budget – actual cost
Cost variance (CV) can be calculated by subtracting the actual cost for a project from the planned budget. This can be analyzed at any time during a project by taking the percentage of completion and multiplying it by the planned budget, then subtracting costs to date.
General contractors may want to break a project down into its scopes to see where the project progress by subcontractor. If any project or item is over budget, it is good to analyze that item and to find out why it went over.
Construction estimators and project managers can use a project’s cost variance as a learning opportunity for the next one.
Planned hours vs actual
For contractors providing labor on a project, it is recommended that you compare the budgeted hours with the actual once the project is complete. There’s nothing to calculate here – this is a simple comparison. But it’s important that you keep good records to compare budgeted hours with your actual hours on the job.
If your actual hours are higher on a project than planned, it means your labor costs are eating into your profit margin. If there is an overage, look into it and find out what caused it so it can be planned for in the future.
Also, if the budget overstates how long the work will take, figure out why and adjust it for the next project. This will help make bids more competitive and jobs more profitable.
Percentage of labor downtime
Percentage of labor downtime = Downtime hours / total hours
Percentage of labor downtime helps you calculate productivity on a construction project. You want this number as close to 0 as possible; that means your field staff are working 100% of the time.
It is important to measure the efficiency of workers when they are providing labor for a project. But downtime hours can be difficult to document: No one wants to admit that they weren’t being productive.
Ask workers to be as honest as possible about their productivity (without repercussions), as it will help the company improve its overall effectiveness.
Find the KPIs that matter to your construction business
KPIs can help contractors learn more about their business health. Depending on your priorities figure out ways to be more profitable and efficient, even in uncertain times. When you review your KPIs over time, they offer insight into what trends to expect in the future and how well your construction business handles adversity.
Understanding your business performance is especially critical during – or heading into – a recession. Having a good sense of your KPIs can help you put your construction company through a stress test, to ensure you are prepared for a potential downturn.
The key is to pick just a few KPIs to start, so the information isn’t overwhelming. Get to know those indicators and what they mean before adding more. Be creative and find the KPIs that are important to your construction business – and your bottom line.